The past several months have seen a flurry of activity in the official sector regarding the Treasury market, as policy-makers and stakeholders attempt to explain the startling dislocations that hit the Treasury market – generally considered to be the world’s deepest, most liquid securities market – in March 2020.
Indeed, it was only through swift, aggressive intervention by the Federal Reserve that said market dislocations did not become even more pronounced. It marked the second time in just a few years that the central bank had to intervene in the US Treasury market to restore and encourage orderly operations – the other time being the Fed’s purchase of Treasury bills in autumn 2019, which was designed to stabilise the short-term interest rate market.
So what led to the Treasury market dislocations and illiquidity back in March 2020? At a high level, the prevailing narrative is that several factors occurred all at once to create a perfect storm.
- Leveraged market participants who exploited basis trades in cash futures markets were forced to unwind positions due to stop outs and garnering repurchase agreement financing.
- For a number of reasons, many dealers and market-makers were sensitive to the growth of their balance sheets during volatile market periods. (For bank-affiliated broker dealers, the supplementary leverage ratio’s treatment of Treasuries may have impacted intermediation.)
- Many non-US central banks and governments sold US Treasuries to meet their expected liquidity and currency exchange rate policy needs.
- Many liability-driven investors rebalanced their portfolios into equities, reducing demand for longer-duration US Treasuries.
- Government-only money market funds saw substantial inflows, boosting demand for T-bills and placing severe pressure on the front end of the market.
The official sector’s robust and largely effective response to the above developments in the midst of the Covid-19 crisis has been well detailed by policy-makers and observers alike. And it is clear that Treasury securities remain one of the most important channels for the execution of monetary policy, almost requiring the Fed’s attention during periods of market upheaval. Yet it is equally clear to many market participants that more needs to be done to protect the Treasury market for the longer term.
If the global reserve currency’s (the dollar) sovereign debt market undergoes further periodic bouts of dysfunctionality, particularly at the exact moments when investors may need it most for liquidity and price discovery, then Treasury market behaviour is likely to fuel broader market volatility.
However, future episodes can be mitigated. The Fed’s standing repo facility, launched in the early days of the pandemic, was a good start towards fortifying the Treasury market for the years ahead. More rapid expansion of this facility to a wider range of market participants (not just primary securities dealers) will be critical to its long-term efficacy, as will be the permanence of the Foreign and International Monetary Authorities’ repo facility.
There is also an evolving consensus on expanding central clearing for both Treasuries and Treasury repo. While operational challenges remain, over time, this is likely to enhance the capital efficiency and resilience of the US Treasury market due to netting and counterparty management.
One underexplored route in efforts to strengthen the US Treasury market is the potential establishment of a Treasury buyback programme. The Treasury department can and, I believe, should execute buybacks either via outright purchases or through ‘switch’ operations.
For the sake of this discussion, these operations could either: 1) buy back existing, less liquid ‘off-the-run’ securities in exchange for balances held at the Treasury General Account; or 2) allow market participants to receive T-bills or some predetermined ‘on-the-run’ securities. Switch operations like these would give the US Treasury the ability to relieve market pressure and improve market liquidity during periods of heightened volatility. There is also an argument for these operations to become a more ‘normal’ part of the Treasury’s toolkit (and not just for highly volatile periods).
The Treasury would be able to better manage its overall weighted-average maturity profile, while also smoothing out security issuance and cashflow volatility related to large coupon payments and maturity dates. The process could temper the issuance volatility that often results from seasonality and having to maintain a minimum TGA cash balance with the Fed. This additional flexibility may reduce the need to maintain a large cash buffer at the TGA.
In short, a Treasury buyback programme would deliver benefits and be consistent with the Treasury’s policy of regular and predictable security issuance.
The Federal Reserve Bank of New York, as part of its role as fiscal agent for the Treasury, would still be likely to execute these operations. However, overall strategy would be set by the Treasury in line with achieving the above objectives, while further strengthening Treasury market functioning.
The ‘wake-up calls’ provided by the market turmoil of 2019 and (especially) 2020 have underscored the need for a more proactive approach to ensuring that the US Treasury market remains orderly, functional and robust for the long run.
Amar Reganti is Fixed Income Asset Strategist at Wellington Management and former Deputy Director of the Office of Debt Management, US Treasury.